Mean It When You Elect S Corporation Status

I am looking at an odd case.

I see that the case went to Tax Court as “pro se,” which surely has a great deal to do with its general incoherence. Pro se generally means that the taxpayer is representing himself/herself. Technically this is not correct, as I could represent someone in Tax Court and the case still be considered pro se. There was no accountant involved here, however, and it shows.

We are talking about Hong Jun Chan. 

He founded a restaurant named Younique Café Inc (YCI) in August, 2010.

In March, 2011 he filed an election with the IRS to be treated as an S corporation. All the owners have to agree to such an election, and we learned that Chan was a 40% shareholder of YCI.  

Let’s fast forward to 2016.

Chan and his wife filed a joint tax return for 2015, but they did not include any numbers from YCI. That does not make sense, as the purpose of an S corporation is to avoid corporate tax and instead report the entity’s tax numbers on the shareholder’s individual/separate return.

A year later the Chan’s did the same with their 2016 joint tax return.

This caught the attention of the IRS, which started an audit in 2019. The revenue agent (RA) found that no business returns had ever been filed.

Standard procedure for the IRS is to contact the taxpayer: perhaps the taxpayer is to visit an IRS office or perhaps the audit will be conducted via correspondence. The IRS did not hear from Chan. Chan later explained that they had moved to Illinois and received no IRS correspondence.

The RA went all Kojak and obtained YCI’s bank records. The RA added up all the deposits and determined that the Chan underreported his taxable income by $1,139,879 and $731,444 for 2015 and 2016 respectively.

Yep, almost $2 million.

Off to Tax Court they went.

Chan had a straightforward argument: YCI was not an S corporation. It was a C corporation, meaning it filed its own tax returns and paid its own taxes. Let’s be fair: the restaurant had gone out-of-business. It is unlikely it ever made money. Unless there was an agency issue, the business tax could not be attributed to Chan personally.

Got it.

ISSUE: YCI filed an S election. The IRS had record of receiving and approving the election. YCI was therefore an S corporation until it (1) was disqualified from being an S, (2) revoked its election, or (3) failed an obscure passive income test.

PROBLEM: YCI was not disqualified, had no passive income and never revoked its election.

But …

Chan presented C corporation tax returns for 2015 and 2016. They were prepared by a professional preparer but were not signed by the preparer.

COMMENT: That is odd, as a paid preparer is required to sign the taxpayer’s copy of the return. I have done so for years.

The IRS of course had no record of receiving these returns.

COMMENT: We already knew this when the RA could not find a copy of the business return. Any search would be based on YCI’s employer identification number (EIN) and would be insensitive to whether the return was filed as a C or S corporation.

Hopefully Chan mailed the business return using certified mail.

Chan had no proof of mailing.

Of course.

At this point in the case, I am supposed to believe that Chan went to the time and trouble of having a professional prepare C corporation returns for two years but never filed them. Righhhttt ….

But maybe Chan thought the preparer had filed them, and maybe the preparer thought that Chan filed them. It’s a low probability swing, but weird things happen in practice.

This is easy to resolve: have the preparer submit a letter or otherwise testify on what happened with the business returns.

Crickets.

The IRS in turn was not above criticism.

It added up deposits and said that the sum was taxable income.

Hello?? This is a RESTAURANT. There would be food costs, rent, utilities and so forth. Maybe the RA should have spent some time on the disbursement side of that bank statement.

Then the IRS charged 100% of the income to Chan.

Hold on here: didn’t Form 2553 show Chan as owning 40% - not 100% - of YCI?

We don’t believe that, said the IRS.

Both sides are bonkers.

Chan went into Tax Court without representation after the IRS tagged him with almost $2 million of unreported income. This appears a poor decision.  

The IRS - relying on a Form 2553 to treat Chan as a passthrough owner – could not keep reading and see that he owned 40% and not 100%.

Can you imagine being the judge listening to this soap opera?

The Court split its decision:

(1) Yep, Chan is an S corporation shareholder and has to report his ownership share of the restaurant’s profit or loss for 2015 and 2016.

(2)  Nope, both sides must go back and do something with expenses, as well as decide Chan’s ownership for the two years.

Our case this time was Hong Jun Chan and Suzhen Mei v Commissioner, T.C. Memo 2021-136.